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What is Going on with Crypto?

Written: December 2022

Based on calls, tweets, texts, and emails about crypto from friends and family, I decided I should write an article about it. I do not claim to have all the answers, but I do have some experience in this developing area. The purpose of this article is to share what I have learned and what I believe the future will hold.

A crypto exchange called FTX imploded and went bankrupt. The value of the company went from around $30 billion to a figure yet to be determined but a small fraction of the billions. Last Christmas, Bitcoin was trading at $50,663, according to CoinGecko. The price today is down 66%. Some are linking the two phenomena and others are saying the FTX failure is the end of crypto. I don’t think so. I will start with crypto exchanges.

In addition to FTX, other exchanges are Binance, Bitfinex, Coinbase, crypto.com, Gemini, Kraken, and KuCoin. There are hundreds more around the world. A simple explanation is a crypto exchange is for crypto what Fidelity, Merrill Lynch, Schwab, et al are for stocks and bonds. Exchanges are developing technology to provide a transparent financial system to enable efficient buying, selling, holding, and transferring of digital assets. In the case of FTX, the man at the top, Sam Bankman-Fried, had more expansive ideas.

SBF, as he is known, devised techniques for arbitrage whereby he would buy crypto on one exchange and sell it on another exchange which may have a slightly higher price. The price of Bitcoin or any other cryptocurrency varies slightly from exchange to exchange. Through high-speed computing and networking, he was able to make millions from the arbitrage. One of the many problems was he had no accounting system to keep track of the trades and no risk management system to gage the potential backfiring of the arbitrage. Some very smart venture capitalists invested large sums of money in FTX and related companies of which there were a bunch. VCs are used to taking risks and sometimes losing a lot of money. Crypto is definitely risky. The VCs invest in ten things knowing most of them would go belly up but hoping to get at least one home run plus a few triples and doubles. Unfortunately, some of the investors were the employees who took part or all of their pay in crypto. FTX developed its own token called FTT. It had no intrinsic value but large amounts of it were created. Loans were made using FTT as collateral. Customer deposits were used to lend to others with no transparency. When the bubble broke for FTX, the FTT quickly went to zero.

FTX and SBF will be in the news for years. Some are saying the FTX failure is bigger than the Enron failure of 2007. SBF was interviewed in New York this week against the advice of his lawyers. He is trying to create a new image as an innovative founder who intended to make billions and give it to charities. He claims he genuinely cared about his customers. Although fraud looks obvious, I think it may prove difficult to prove his intention was to commit fraud. One thing for certain is he was incompetent at running a multi-billion-dollar organization.

I believe some good things will come out of the failure. The need for some form of regulation has been clear for several years. It is no excuse but our government has been really slow to step up to the problem. There is not even agreement as to what agency should be the regulator. I believe both the SEC and the CFTC will play a role because some crypto is viewed as currency and some as commodities. Another thing coming out of the debacle is the move toward proof-of-reserves. Crypto has been used as a way to create loans. The problem has been that lenders and borrowers have had no way to know what is backing up the loans. An innovative approach will enable proof-of-reserves to be incorporated in the blockchain infrastructure which enables crypto to work.

Since 2009, there have been 511 bank failures. When a bank fails, the process to unravel things is well understood. The FDIC insures up to $250,000 per account. In the case of FTX, it is a total mess. The winners are going to be the many lawyers who will be part of the cleanup and participate in lawsuits. Now a few words to add perspective about other exchanges.

In April 2021, Coinbase became the largest publicly traded crypto company in the world. 108+ million users are trusting Coinbase. The company operates with financial transparency and makes its financial statements available each quarter. Coinbase says, “Your funds are your funds, and your crypto is your crypto.” Coinbase maintains internal systems, like a bank or a broker. Coinbase has detailed documentation on its website for all board committees including Audit and Compliance Committee, Compensation Committee, Nominating and Corporate Governance Committee, Code of Business Conduct & Ethics, and Corporate Governance Policy. I am sure FTX had none of these.

Binance is a cryptocurrency exchange which is the largest exchange in the world in terms of daily trading volume of cryptocurrencies. It was founded in 2017 and is registered in the Cayman Islands. Binance was founded by Changpeng Zhao. In addition to a Chief Financial Officer, Binance US has a Chief Risk Officer and Chief Compliance Officer. I am sure FTX had neither. Zhao said Binance would begin to publish its reserves, starting with its Bitcoin reserves. In a web page published Nov. 25, Binance reported it held nearly $10 billion of Bitcoin in its own account and another $10 billion in customer deposits. It said it would be adding information about other crypto soon.

Crypto exchange Kraken has provided regular proof of reserve audits for years, using an advanced cryptographic procedure called a “Merkle tree” which is conducted by an independent auditor. FTX was a disaster, but I do not believe we should paint all exchanges with the same brush. The failure of FTX is not a failure of crypto, it is a failure of Sam Bankman-Fried.

Secretary Yellen said in New York this week it was important to be open to financial innovation. She indicated blockchain technology underlying cryptocurrencies has the potential to provide faster and cheaper transactions. She emphasized sufficient consumer protections are needed. Yellen said, “I think everything we’ve lived through over the last couple of weeks, but earlier as well, says this is an industry that really needs to have adequate regulation, and it doesn’t.” Right. Let’s get working on that.

To put crypto overall in perspective, consider the fact there are 21,908 cryptocurrencies as of this writing. You will often see a cryptocurrency referred to as a token. They are the same thing. The market capitalization, the number of tokens times the current price, is $860 billion. Of that total, 38.2% is Bitcoin and 18.3% is Ethereum. The other 21,906 tokens were 43.5%. Most of those are bogus or jokes or tokens invented but with no value. I suspect most were created by computer science people who knew how to create them and did so.

I have been investing in crypto since 2013. I hold 25 different tokens (cryptocurrencies). Of my total holdings, 95% is Bitcoin and 3% is Ethereum. The remaining cats and dogs are totally speculative. I have no expectations for them. Crypto is risky. I never recommend investing in it unless you are prepared to lose it all.

Although risky, I believe digital assets are the future. Physical coins and paper are not the future. Money transfers which can take 3-5 days are not the future. Non-fungible tokens (NFTs) are the future (see the Crypto chapter in my new book, Reflection Attitude: Past, Current, and Future). Asia and Europe are moving much more quickly than the U.S. The regulators are ready to go but they need authorization by Congress to implement regulations. The House Financial Services Committee has 54 members. It is chaired by a member of the house who is 84 years old and has no business or technology experience.

Finally, where is the price of Bitcoin headed? Nobody knows. Cathie Wood, the founder, CEO and CIO of Ark Invest, has forecasted the price will be $1,000,000 by 2030. Other pundits have forecasted the price is headed to $0.00 sooner rather than later. In 2021, gold performed better than Bitcoin. Overall, over five years, while the average return on gold was around 11%. For Bitcoin it was around 112%. The next five years, nobody knows. I am optimistic because technologists are working to make Bitcoin mining more efficient and to make transaction processing much faster and cheaper. The bottom line, nobody knows.

Disclosure: I am an investor in Coinbase.

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