Guest post by: Martin Walker
Big Crypto executives seem to have a huge problem understanding basic concepts of conventional finance such as balance sheets, auditing and cash flow.
Changpeng Zhao, aka: Binance cryptocurrency exchange “CZ”, recently described how they managed more than $580 million in FTT crypto tokens; “We never touched it, actually kind of forgot about it.” Sam Bankman-Fried has expressed endless confusion about the management of assets by the FTX cryptocurrency exchange and the Alameda hedge fund.
Even before the collapse of FTX, Sam had some unusual ideas about the methods the crypto industry uses to create value;
… the smart money is like, oh wow, this thing is now paying 60% a year on X tokens. Of course I’ll take my 60% return, right? So they go and put another $300 million in the box and you get psychology and it goes to infinity. And then everyone makes money.
Cynics, like much of the mainstream media and the Securities and Exchange Commission (SEC), have finally come around to the idea that most of Big Crypto is run by people who are recklessly incompetent and/or criminal. Perhaps some of them are. But it’s worth trying to understand how billionaires (and more recently ex-billionaires) have developed their understanding of the financial world.
Back in 2016, I co-authored a paper stating that cryptocurrencies like Bitcoin are “assets without liability.” In other words, “created out of thin air, contrary to the laws of double-entry bookkeeping.” Financial assets are always someone else’s liability. If they are not a liability of another party, who will pay for the return of the asset that ultimately provides value? No one, therefore they have no fundamental value.
The big Crypto companies have been buying and selling “nothing” for so long, mostly for different pieces of “nothing”, that many have truly believed that taking nothing, giving a name, and sometimes a story, have been combined; Trading back and forth with friends adds enormous value to “nothing”.
Whether the huge valuations of nothing tokens came from old-school cryptocurrency market price hikes or the creation of complex DeFi (decentralized finance) structures, the belief in the value of nothing is easy to ignore the underlying reality. It is the inflow of real money that gives crypto assets value, not “technology”, “community”, “network” or “freedom”.
A crypto enthusiast struggling with the idea that financial assets have corresponding liabilities should consider the concept of the balance sheet. Unfortunately, this misunderstanding of basic accounting is reinforced by fundamental misunderstandings of banking and economics.
Big Crypto executives, including those regularly interviewed by the likes of CNBC, mostly seem to have learned about banking and finance by regurgitating each other’s tales based on ultimately ancient tweets and blogs about the Austrian economy. Most of them seem to genuinely believe that banks are “making money out of thin air” by selfishly enriching themselves and defrauding the public by causing inflation. If they had some understanding of balance sheets, they could understand how lending creates both an asset (loan) and a liability (funds in the borrower’s account) for the bank, and that the bank does not create money for itself. from nothing, even with an amount controlled by the requirement to have sufficient capital.
Oddly enough, given the contempt for inflation that creates fiat money, Big Crypto really does create “money” out of thin air. Their preferred way of dealing with the resulting dissonance is based on further misunderstanding. They believe that having a fixed supply of any given token that represents “nothing” protects against inflation. Even as some major cryptocurrencies like Ethereum and Dogecoin do not have a fixed supply.
Maybe if they studied some basic monetary economics and learned all four letters of the quantity theory of money equation;
In plain English, the price level (P) is only held constant; i.e no inflation if the velocity of money (V) is constant and: there are real costs on goods and services (Q); Since there is no actual spending of crypto on goods and services, it doesn’t really matter that the money supply is fixed.
Which brings us to the crypto industry’s struggle with the concept of auditing. CZ: about auditing companies stated that “Most of them don’t know how to audit crypto exchanges.” Since the crypto industry largely lives outside the fundamental laws of finance and economics, what hope do auditors have of applying their antiquated ideas about assets, liabilities and balance sheets? Very few, but not just because the crypto industry is struggling to understand the basics.
One of the tenets of the crypto faith is that everything is transparent “because it’s on the blockchain.” Audits are not really necessary, and if they are to be performed, they involve complex mathematical analysis. Unfortunately, blockchains don’t make things transparent in the old-fashioned way that auditors love. A certain amount of crypto may be stored at a certain address on the blockchain, but that does not mean that it is under the control of the audited party. An auditor cannot simply see an asset in the accounts and match it with the bank statement.
In the crypto world, the best guarantee that you own the crypto you’re going to mine is to move some crypto from one address to another and hopefully back again, as Craig Wright famously failed to do. Unfortunately, even that offers a limited warranty. A routine audit can check who has permission to transfer funds from a bank account. In the crypto world, anyone who has seen the private keys associated with crypto funds can retrieve them, and there is no central party to ask if they are authorized or even reverse the transaction.
Hopefully the reader now has a little more sympathy for the poor confused leaders of Big Crypto. If any of them unfortunately end up in jail, the least society can do for them is to provide them with basic accounting and economics training. Something that would certainly help with the recovery. Perhaps taking the right courses could have been a condition of parole to study harder.