Cryptocurrency has turned into an inferior version of the money Satoshi Nakamoto set out to replace.
In the first bitcoin ‘block’, the cryptocurrency’s creator embedded a message: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”. By doing so, Nakamoto was tapping into a groundswell of popular discontent.
It was the banks which had been at the centre of the decade’s real estate frenzy. It was the banks that had lent recklessly while backed by only a sliver of capital. It was the banks who kept playing games with other people’s money. And it was the bankers who kept privatising their gains and socialising their losses.
The investment bankers were the most highly paid and reckless of the lot. They sat at the nexus of a complex and largely hidden financial network, pulling the strings and paying themselves mansion-sized bonuses.
Nakamoto was tapping into a groundswell of popular discontent
Around the investment banks sat opaque ‘shadow banking’ institutions: hedge funds, structured investment vehicles, special purpose entity conduits, money market funds, repurchase agreement (repo) and securities lending markets.
Many of these entities were doing the same thing as banks—taking in deposits, promising to redeem them on demand, then seeking extra earnings by taking on credit and liquidity risks—but outside the banking rules.
Those rules, as we found out in 2008, were imperfect. Banks weren’t capitalised enough and they were involved in too much proprietary trading. But at least the bank regulations guaranteed some transparency and a minimum of capital backing for risky lending.
In the shadow banking market, by contrast, it was a free-for-all.
American insurance giant AIG could find itself writing nearly a trillion dollars of cover against price declines on mortgage-backed bonds, but without the collateral to back those guarantees.
Clients of a London-based hedge fund could find their assets had been lent out many times over by the investment banking firm designated to look after them—and had disappeared or were frozen by the bankruptcy courts when the intermediary went bust.
Shadow banking meant that savers in pension funds suddenly found their retirement assets depleted when their pension fund manager lent out their shares and bonds for some extra revenue, incurring losses when the borrower defaulted and the collateral turned out to be risky.
It’s not surprising that Satoshi Nakamoto, and millions of others, got upset when they saw so much public money—$29trn, by one estimate—diverted to shore up private institutions.
The list of bailout programmes created by governments and central banks to hand out the cash in 2008 is bewildering: Term Auction Facility; Central Bank Liquidity Swaps; Single Tranche Open Market Operation; Term Securities Lending Facility and Term Options Program; Maiden Lane; Primary Dealer Credit Facility; Asset-backed Commercial Paper Money Market Mutual Fund Liquidity Facility; Commercial Paper Funding Facility; Term Asset-backed Securities Loan Facility; Agency Mortgage-backed Security Purchase Program; AIG Revolving Credit Facility; AIG Securities Borrowing Facility.
But if bitcoin was meant to fix the financial system, the financial services that have grown up around cryptocurrency are repeating the mistakes of 2008.
In 2008, it was a decline in the shares of a popular money market fund to below their stated $1-per-share value that precipitated the crisis. That money market fund had invested its clients’ money in bonds that were supposed to be safe but which weren’t.
The financial services that have grown up around cryptocurrency are repeating the mistakes of 2008
In Tether, we now have a $70bn, unregulated and opaque version of the same structure.
It’s Tether that provides 70 percent of the trading liquidity in bitcoin, while disclosing only very limited information about its asset backing.
According to Bloomberg (and undenied by Tether), part of the stablecoin’s reserves now consists of billions of dollars of short-term loans to unnamed large Chinese companies, where secondary market debt prices are already on the slide.
Bloomberg also said that Tether had made loans worth billions of dollars to other cryptocurrency companies, receiving bitcoin as collateral.
What about the other shadow banking practices of 2008?
In 2010, IMF economist Manmohan Singh wrote a paper in which he pointed out that clients of London-based hedge funds had been particularly exposed to the lending of their assets by the investment banks acting as intermediaries (prime brokers).
“In the United Kingdom, such use of a customer’s assets by a prime broker can be for an unlimited amount of the customer’s assets,” he said.
“All digital assets transferred to Celsius as part of the services are owned and held by Celsius for its own account”
In other words, the same assets can be lent out in collateral ‘chains’, creating near-infinite leverage: the client assets pledged by the investment bank as backing for the first loan are taken by that lender and reused for another loan, and so on.
Now, in the cryptocurrency market, cryptoasset lenders like Celsius Network, BlockFi and Nexo take in client assets in return for the promise of an interest rate, then reuse them as they please.
“When you transfer digital assets to Celsius, those digital assets are a loan from you to Celsius…all digital assets transferred to Celsius as part of the services are owned and held by Celsius for its own account.”
Cryptocurrency has fully replicated the shadow banking sector’s opaque collateral chains.
For example, Celsius says it will pay 3.51 percent on a deposit of over 1 bitcoin. Then it can go to Tether and pledge that bitcoin (which Celsius now owns, remember) against a loan of tether tokens.
Celsius’s CEO told Bloomberg recently it pays around Tether 5 to 6 percent a year for such collateralised loans.
Then Celsius can take the tether tokens it has received and lend them out at even higher rates in the hedge fund market or to other cryptocurrency counterparties.
KuCoin, for example, currently advertises an annualised interest rate of over 30 percent for anyone willing to lend out tethers on its platform for 28 days.
On Cake, a popular decentralised finance (DeFi) platform, you can stake your tethers into so-called ‘yield farming’ pools and, in the platform’s words, “mine popular coin pairs for high rewards with minimal fuss”.
Cake says doing that will earn tether stakers up to 63 percent a year.
“It’s awful – Why did nobody see it coming?”
Some observers are already warning that such practices are creating an unhealthy cocktail of hedge fund/cryptocurrency relationships that could easily spill over, without warning, into the broader financial system.
Elsewhere, more and more people are borrowing against their cryptocurrency holdings to buy homes, cars and more crypto.
When the Financial Times reported at the weekend that tax authorities are seeking to crack down on cryptocurrency holders and to force them to pay capital gains tax on disposals, the most popular comment at the foot of the article was:
“You do not need to sell your crypto, you can borrow against it using platforms like Blockfi and Celsius, not realise any gains and starve the beast of tax revenues used increasingly to oppress citizens.”
In 2008, Queen Elizabeth II famously asked, in response to the failure of Lehman Brothers and the ensuing credit crunch: “It’s awful – Why did nobody see it coming?”
Now we have created a repeat of the conditions of 2008. Only this time there are no safeguards, near-zero transparency and a much more volatile asset—cryptocurrency—at the centre of the system.
Sign up here for the New Money Review newsletter
Click here for a full list of episodes of the New Money Review podcast: the future of money in 30 minutes
Related content from New Money Review
Digital currency – a central banker’s view