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The collapse of cryptocurrency exchange FTX makes the headlines but nothing that is happening should have been unexpected. A financial system collapsing is not an unheard-of event. Markets have crashed in the past. Banks have failed. What happens when this occurs is that the people whose assets have been placed into the custody of that institution become frozen and inaccessible to their owners for some time.
An exchange works on the concept that it never has to pay out the full amount of what is called the unrealized value of the assets in the exchange. That’s because they don’t have the money on hand to pay everyone if everyone wants to cash out at the same time. In a working exchange, the real money going in and out of the books is a small fraction of the assets under administration. Until everything goes wrong. The exchange runs out of reserves. A sudden drop in the value of the crypto markets can trigger this type of run. Lacking the cash to pay their investors, they must declare bankruptcy.
Pirates of the Caribbean
The exchange then needs to be closed out, which is what FTX is now attempting to do. If someone with an FTX account has cryptocurrency in their wallet, that wallet could eventually return to their possession as the process of resolving the exchange plays out. It might have whatever spot value it has in the market whenever it becomes a liquid asset for the owner again. Unfortunately, this value is typically far less than its value was before the exchange fell. Particularly at risk is any speculative cryptocurrency that dies with the exchange because the loss of the internal market within the exchange for it means it ceases to be a viable “coin.” Those investments could be a total loss because the owner does not have access to trade it.
What’s new and interesting in the case of FTX is that the bankruptcy capsule of the exchange seems to have sprung a leak. A loophole in the Bahamas allows persons there to withdraw assets from the defunct exchange. This seems to have created a rather unique opportunity for a latter-day group of “Pirates of the Caribbean” to buy panicked investors’ crypto assets for pennies on the dollar taking advantage of another blockchain device, the so-called Non-Fungible Token (NFT). They use the NFT to transfer the ownership of a wallet from a trapped illiquid investor account to that of someone eligible to use the Bahamas withdrawal loophole to get the value out of FTX. The toll is a steep one. The value of the NFT is discounted heavily because, among other things, the math considers the anticipated loss in value of the wallet. Also, the people taking advantage of the panicked investor will be quite greedy and predatory. The original investor loses bigly while the NFT holder takes the lion’s share of the wallet. In junk investing, it’s called the “yield to the end” computation. The end can happen abruptly.
That’s not that different from what can happen when one invests in any highly speculative instrument like a junk bond. The main difference between regulated markets and crypto exchanges is that high-risk investments are restricted to qualified investors who can afford to lose the entire initial stake. In crypto, anyone can play with fire.
Trading Places
Investors who make “leveraged” investments in the exchange, meaning those who used money they did not have, to buy cryptocurrency that relied on being able to quickly get their money out in time to cover their borrowings are particularly hard hit by this kind of crisis. They will experience a catastrophic cash flow disruption and, like the mythical “Duke and Duke” from the movie “Trading Places,” be unable to pay their margin call. The adage that you should never bet what you cannot afford to lose when gambling applies here. But not everyone heeds this wise caution; and as FTX went dark, many are now paying the price of biting off more than they can chew.
Crypto Is Still Learning to Be Currency
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The functional reason to use cryptocurrency is to make transactions as a substitute for using regular cash. This is particularly handy for moving money between countries where regular economic exchange has fallen apart. A common situation is a country that has fallen into war, with people in that country needing to get money from relatives in other parts of the world. Cryptocurrency is one means of making this happen; but it’s not the only one. In some parts of the world, a paper form of cross-border money transfers called “Hawala,” which has been around for centuries, is used for similar purposes.
You take real money from wherever you are and put it in an exchange where it disappears into a bookkeeping system. At the other end of your transaction, the person you are sending money to or paying takes the money out of the exchange and converts it back into real money. In circumstances where normal economic rules apply, this is called a “payment processing system.” Common forms of this in the western world are cash payments, payments by check, credit card transactions, wire transfers, and other non-barter forms of payment.
CoinDesk estimates a daily transaction volume of $20 to $35 million dollars per day for Bitcoin’s Lightning network. The average transaction for a Bitcoin payment is around $94.00 which works out to around 300,000 to 400,000 transactions per day. The average transaction for all other forms of cryptocurrency is less than $20.
In the universe of cryptocurrency, this is a very minor use of this form of substitute money. The estimated asset value of the cryptocurrency in the world runs between $1 trillion and $3 trillion USD depending on who you choose to believe on any given day. But if you look at the total assets versus the assets used to support transactions numbers of even the most mature of the cryptocurrencies, such as Bitcoin’s Lightning network, according to the website CoinDesk, there’s only around $150 to $200 million dollars in bitcoin available to support payments processing on any given day. So, what is the rest of it going into? The answer is speculative investing.
Casino Royale
This is where you convert real money into cryptocurrency by putting your hard-earned cash into an exchange. Then you wait and hope the value of your crypto rises the same way gold or stocks rise in their respective markets and exchanges. Eventually, you reap your winnings by taking your credits out to the exchange and turning them back into real money.
If you are lucky, you might turn one dollar into over $16,000. Buy low, sell high. A $10,000 investment in Bitcoin in its early days would be the equivalent of winning a $2 billion lottery several times in a row. But investment is a form of gambling. You can easily lose all your money too. People do lose in the wild swings of cryptocurrency. Many have made the mistake of buying high and seeing their coin’s value evaporate.
Fraud and Scams
Lastly, because the bulk of cryptocurrency assets are being used for speculative investing, it attracts an unusually large number of fraudulent players seeking to take advantage of people who do not understand the risky nature of their investments. In July 2022, Motley Fool reported that over 46,000 people reported cryptocurrency frauds to the Federal Trade Commission between the beginning of 2021 and the first quarter of 2022. The most common schemes involved getting people to buy cryptocurrency then send it to the scammer where it would disappear into the ether, never to be seen again. Lacking regulatory oversight, this is easy money for the unscrupulous. At a recent economic conference I attended, an updated report I heard from OCC Acting Comptroller Michael Hsu indicated that crypto fraud incidents tracked by US regulators now indicate they emerge as often as a new one every four minutes.
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