Dominoes Falling
General objection to the rise of crypto skepticism. Tether — is the other shoe still to drop?
Boy, are we suckers for sensation. During Railway Mania in 1840s, one of the more interesting from a long list of times when men succumbed to madness and greed, more than 6,000 miles* of railroads were built in the space of 2 years, with tracks furiously criss-crossing England, as people rushed to invest in speculative companies set up to raise funds in a mad building rush. Everyone must have a piece of a railroad company, the new revolutionary technology that was going to make the world infinitely faster.
And it did! But first:
As soon as the newly formed companies began running the railroads, underutilized and at a loss, while at the same time the Bank of England increased interest rates (yes, a recurring theme), money started flowing out and the bubble burst.
There is some wonderful analogy that I cannot quite put my finger on, between the redundant rails of the 1840s and one too many blockchains of the 2020s.
Everyone Played a Bank
The crypto dominoes are falling, as the opaque lending relationships come to light, and the defaults spread from one crypto platform to another. Worse, there is this creeping feeling in the market that the other shoe is still about to drop.
By now, you must have seen the story of how it happened almost everywhere else:
The $40B implosion of Terra seemed contained at first, but then it began spreading wider. This in combination with general macro deterioration and rising interest rates pushed the prices of thousands of tokens down, in effect reducing the value of collateral put up against loans taken out by the largest crypto hedge funds (Three Arrow Capital) and crypto lenders (Celsius).
The prices continued falling across the board, leading to margin calls, and eventually, the unraveling of the opaque recursive borrowing relationships between many of the centralized crypto platforms.
On the way up, everyone wanted to play a bank. Take money from depositors, pay them lower rates (still very high, its crypto!), lend their money at a higher rate somewhere else (hedge funds, DeFi protocols, Terra), while keeping a thin equity layer** (i.e. own capital, which should serve as a buffer to protect their depositors from losses).
On the way down, they are reliving the story of a bank run, played again and again hundreds of times in the traditional finance world, only this time, no one is coming to the rescue.
Crypto Lehman Moment
Nothing about the crypto crash is about crypto. Everything about it is about human nature. Crypto is not crashing because of a failure in some smart contract, but because men recreated the learned mistakes of 2008 on top of crypto.
Notice that the essence of what caused 2008 — that drive to lever asset’s value to the limit, to create several layers of debt on top of every asset — seems to be a recurring theme.
There is a transformational technology called crypto. It attracts interest. At times it causes madness of crowds. When this happens, tourist projects also emerge in crypto, bringing half-baked business concepts from the old world.
Centralized crypto platforms like, I don’t know, Celsius did the exact same thing that is happening in financial world every day. They were lending money of their depositors. They were lending money against collateral.
Sometimes, say, when they were lending to large businesses, they were only asking for 50% collateral on the value of loan. Maybe they were rehypothecating the collateral they held to borrow themselves and do some riskier high-return investing.
So you see, they were doing the exact same thing that is happening in the financial world every day, except in complete absence of regulatory and legal guardrails that are keeping this sort of stuff in check, not out of some pure genius present in the financial world, but because the old finance has done these mistakes before and is shaped by them.
We Haven’t Seen Peak Crypto Yet
If crypto in its original form (bitcoin) is removing middlemen from the transfer and ownership of financial wealth, and in its programmatic form (ethereum and the likes) is trying to remove middlemen from all socio-economic processes, then the 2022 crash has nothing to do with it.
By simple logic, decentralized, technology-heavy, product-light cryptocurrencies (i.e. bitcoin, ethereum vs. some other tokens, whose value derives from the demand for and utility of some product) will not be impacted by recreated shadow banking schemes of the centralized crypto startups.
The Other Shoe to Drop
All eyes are on Tether now, a centralized stablecoin, which, as Matt Levine points out, has about 0.2% equity. In other words, of every $100 deposited, Tether invests $99.8, so if the value of its investment falls by 0.2%, Tether is undercollateralized.
In the event of a bank run, Tether would not be able to make good on all its depositors. Oh and this would be, like, $70B bank run based on latest numbers. Tether may already be undercollateralized. We cannot know that. It is impossible to say from its disclosures.
All we see, is an auditor’s report confirming the value of aggregate balances (cash, treasuries, secured loans, etc.). But that secretive culture could be precisely what protects Tether.
A bank run is first and foremost caused by a panic, the loss of confidence in one’s bank. That doesn’t mean that hedge funds haven’t been shorting or setting up put options on Tether for months now, betting on the fact that the value of its assets is less than the tokens in circulation.
The other reason why Tether could be ok in the end is that it has achieved a critical size. It processes hundreds of millions of $ every day, and it does it without hesitation. It may be an entity pushed onto the edge of financial system led by strange men, but it works.
This could be, incidentally, also a real world proof of why some DeFi projects could attain a real utility value, outside of Ponzi dynamics.
Being completely detached from real world claims, the obvious criticism that DeFi has to face is that it offers higher rates only thanks to Ponzi-like business models, i.e. the new money pouring in pays the interest on the old.
But as I point out in Ponzi-ing its way to legitimacy, this does not necessarily have to be true in the long-term, if some projects attain critical mass.
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* for comparison, in its current state, the post-industrialist 21st century Britain has about 10,000 miles altogether
** not entirely fair, as Matt Levine points out, Celsius equity was around 4.5% vs. U.S. banking capital requirements of 4.5% → Celsius was brought down by its speculative investment method on the asset side
