It Is the Nature of Crypto Businesses to Be Scams

Anyone offering you 8% interest on a savings account-like product is a scammer.

Dear readers,

What I’m about to describe is a simplification of what happened with FTX, but I don’t think it’s an oversimplification.

FTX and Alameda Research are two businesses that were principally owned by Sam Bankman-Fried. FTX was an exchange where customers deposited valuable assets, like US dollars and Bitcoin. FTX loaned those assets to Alameda Research, and Alameda posted collateral for those loans, but the collateral was essentially fictional, consisting of proprietary coins developed by FTX and Alameda — magic beans, more or less. Alameda did god-knows-what with the assets it borrowed — probably it lost a bunch of money trading; it also, we learned in a bankruptcy filing today,¹ loaned $1 billion to Bankman-Fried personally and hundreds of millions of dollars to his business associates. In any case, now the magic beans have fallen to a value near $0 and Alameda is insolvent. Because FTX’s asset book consisted in large part of magic beans and bad loans to Alameda, it is insolvent, too, and the investors who entrusted their assets to FTX cannot get them back. FTX and Alameda are in bankruptcy; if you were an FTX customer, now you’re an FTX creditor, and there will be a process to see what value can be recovered to make you partially whole.

Obviously the details are different, but at its core, this is the same scam that Bernie Madoff ran on his clients.

One thing about what I described above is that this is not a technology story, because FTX was not a technology company. Sure, FTX’s business relied on technology, but so do most businesses. FTX has an app; so does Fidelity, and so does Chipotle, and that doesn’t make them tech companies. FTX was a brokerage, and there were two things that set them apart from a regular brokerage. One is that they dealt principally in nonsense financial products² with no underlying economic value, and the other is that the owners either lost or stole the customers’ money and then lied about their resulting insolvency.³

The main way technology matters here is that it was part of the cover story that convinced members of the public to entrust their wealth to FTX. If you go out to people and say, “Give me your money and it will return 8% a year with little to no risk,” they will probably be skeptical. That’s not how things work. And yet, FTX was in fact offering 8% interest on both dollar and Bitcoin deposits.⁴ They needed a story about why their investment product could sustainably do what normal investments can’t. In Bernie Madoff’s case, he ran an affinity fraud where he targeted people and institutions who believed they had particular reason to trust him because of their shared concerns for the Jewish community. He also bolstered his appeal by cultivating a sense that even accessing his services was difficult and exclusive — the idea was that Bernie had access to some secret knowledge about how to produce high-yet-stable returns and only members of his club could benefit from it. In FTX’s case, they hired celebrities and athletes to sell the idea that cryptocurrency was the future and could produce reliably outsized returns — an idea that was only salable because of the broader irrational crypto mania that exists in certain parts of society and the justification for that mania: that the technology underlying crypto has huge promise, that it will replace traditional currency and banking systems, and whatnot.

This is why I hate crypto so much: it comes attached to a narrative that makes scams possible. Because cryptocurrency assets have no fundamental economic value — unlike stocks and bonds, they do not reflect a claim on the cash flows of some business creating real value in the economy — there can be no such thing as fundamentals-based investing in them. When people invest in crypto, they out themselves as marks for scammers who might believe any nonsense about what something is worth. And therefore it’s the least surprising thing in the world that someone would open up a crypto exchange, offer implausible interest rate terms in order to hoover up billions in customer deposits from the gullible masses, and then misappropriate the proceeds.

And that’s where I think Matt Yglesias goes awry in analogizing the business Bankman-Fried purported to be in to selling shovels at a gold rush:

There’s an old saw to the effect that the best way to make money in a gold rush is to sell shovels. And I took that to be SBF’s strategy. It didn’t really matter whether it was a real gold rush or a fool’s gold rush; he had an opportunity to sell shovels. The fact that SBF was not a particularly strident true believer in crypto seemed not like a true confession that the whole thing was a scam, but like an appealing piece of self-awareness. His stated goal for FTX was to become a software platform for trading all kinds of securities and financial products so as to become less of a “crypto” company.

The thing about shovels is that, ordinarily, when there was a gold rush, there was gold to be dug out of the ground. Participating in a gold rush was not necessarily a good financial decision — it very often wasn’t — but the broad theory of the enterprise was sound: In addition to having various industrial and decorative applications, gold had been used as a medium of exchange for millennia and was, at the time of the more famous gold rushes, the basis of the US currency system; therefore, if you dug it out of the ground, you made money. There was nothing inherently fraudulent about selling those shovels, even to miners who would have been better off staying home. The shovels did what they were supposed to and they came with no representations that you’d actually find gold if you used them to dig.

Even before it went belly-up, we could tell that FTX was not selling shovels. Here’s a description of a product it offered, from NerdWallet:

FTX.US offers up to 8% in interest on both fiat currency and crypto held on its mobile app, and this feature is relatively simple to use if you opt in. Rewards compound hourly, and you can withdraw your tokens at any time.

Eight percent interest, including on currencies like the US dollar, withdraw anytime. How could that work? It can’t work similarly to a savings account — you cannot, in the interest rate environment of 2022, offer 8% interest on a demand deposit account and make a profit.

One way this product can work is if the brokerage is investing the assets in a sufficiently risky manner to produce an expected return greater than 8%. But a rate of return that high must come with substantial risk that the brokerage will lose money and be unable to repay customer deposits. Yet these deposits were not marketed to consumers as risky bets — FTX described its products as “safe” in its own advertising and customers often used these products in a manner similar to a bank account. So that’s not a morally-neutral shovel: It’s making money by misleading consumers as to the risk associated with an investment they’re making.

Another way a product offering an 8% fixed return can “work” is by being fake: You take your clients’ deposits, and credit their accounts with 8% interest on paper, even though you cannot produce a low-risk 8% return. Since 8% is a high interest rate and a lot of consumers believe there are ways to get something for nothing, this offer may draw in a lot of new deposits, and you can use the new deposits to pay off withdrawal requests from the initial depositors. This will work so long as enough new deposits keep coming in to offset the withdrawals; it will fall apart when too many customers try to withdraw their deposits. In other words, the product could be a Ponzi scheme. That’s not a shovel either.

I wish I could say I had noticed the specifically implausible nature of FTX’s offerings before this month. I’ve never met Sam Bankman-Fried, and while I thought it was a little weird that a crypto magnate had become a leading Democratic Party donor and funder of Effective Altruism-related philanthropic causes, I honestly didn’t give him very much thought at all until he ran out of money. But I think people who are now regretting their dealings with Bankman-Fried — whether those dealings entailed trusting him with their wealth, relying on his pledges of future philanthropic support, or allowing him to become associated with one’s ideological movement — would have benefited from adopting some rules of thumb that help me make good decisions in investing and life.

Those rules of thumb are:

• Any crypto-related business is a scam.

• Any person who has gotten rich in the crypto business is a scam artist.

• Any financial product that purports to offer a fixed return out of proportion to its associated risk is a scam unless there is an identifiable and sustainable external subsidy for the return, such as how the federal government subsidizes I-bonds.

Or, to put it in even broader terms: if it seems too good to be true, it probably is.

Very seriously,

Josh

Dall-E seems to reject image prompts containing terms like “polycule” and “orgy” — and besides, the company’s in-house psychiatrist/coach/yenta says its executives, contrary to the rumors, were “undersexed, if anything” — so I had the AI engine make this: “Impressionist painting of a group of FTX employees cuddling on beanbag chairs in a Bahamas penthouse.”

1. As you’ve probably seen people pointing out on Twitter, this filing in the bankruptcy of FTX and its related entities is quite a fun read. It’s from the CEO who has been brought in to clean up this mess, John J. Ray III, who is a very experienced restructurer and liquidator of bankrupt firms. He declares: “I have supervised situations involving allegations of criminal activity and malfeasance (Enron). I have supervised situations involving novel financial structures (Enron and Residential Capital) and cross-border asset recovery and maximization (Nortel and Overseas Shipholding). Nearly every situation in which I have been involved has been characterized by defects of some sort in internal controls, regulatory compliance, human resources and systems integrity. Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.”

2. All cryptocurrency products are nonsense products, but there is a spectrum of nonsenseness; some of the products FTX issued were even nonsensier than Bitcoin and Etherium because they lacked a broad and deep global market establishing their nonsense values.

3. I think a failure to conceive of FTX as a financial company rather than a technology company is behind some of the bizarrely soft coverage Sam Bankman-Fried has gotten in the days since his insolvency was revealed. Of course, a lot of the coverage has been excellent, most notably Matt Levine’s writing for Bloomberg. But on Monday, the New York Times ran an article based on an interview with him that entertained a sympathetic-to-SBF narrative about the fall of FTX whose falseness had become obvious by that point. The backstory is this: Changpeng Zhao, the head of one of FTX’s main competitors, Binance, made statements of concern early this month about the solvency of FTX and the value of its proprietary magic bean coin, FTT. These statements were a key factor, but not the sole factor, driving a market response in the form of FTX customers withdrawing funds and FTT falling sharply in price. Once it became clear that FTX could not meet all client demands for withdrawals, Binance made a tentative offer to “rescue” FTX by absorbing its assets and debts. But after reviewing FTX’s financial information (such as it was — as John J. Ray III noted in that filing, FTX did not really have “accounting” or “records” in the usual sense of those terms) Binance withdrew its offer. There is a version of this story — the one Bankman-Fried would like people to believe — where Binance fomented a liquidity crisis at an otherwise solvent competitor as a strategy to take over the competitor on favorable terms. But now we know that’s not what happened — FTX was already insolvent, and so Zhao’s statements of concern about its solvency were well-founded, and it was never a suitable candidate for rescue because the rescuer would have been on the hook for liabilities that far outstripped assets. The whole world didn’t know this quite as early as Binance did — Binance got a few days of headstart on the rest of us at looking at FTX’s financials — but when they looked they would have been seeing what everyone can see now: an unsalvageable garbage fire.

4. Eight percent interest was available on the first $10,000 of deposits. On amounts above that, FTX was paying 5% — not as tantalizing, but still much too high for a savings-like product in the current environment.